How investors should react to the selloff

Mark Haefele and Kiran Ganesh, UBS Wealth Management

Thursday, 16 Oct 2014 | 3:44 AM ETCNBC.com

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Brendan McDermid | Reuters

Traders on the floor of the New York Stock Exchange.

Market selloffs of the scale we have witnessed over the past few days are not unprecedented. Indeed, this is the fourteenth 5 percent-plus selloff in the S&P 500 since the rally began in 2009. There have been two 10 percent selloffs. What is different about this sell-off is that it is coming from a higher level of valuations, potentially giving rise to increased market nervousness around individual pieces of economic data.

However, we believe investors should still operate under the assumption that stocks will move higher over the next six months.

We remain confident that U.S. economic growth will continue, in spite of Wednesday's data. This should translate into solid earnings growth -- which is already in evidence through the current earnings season. So far 69 percent of companies have beaten sales expectations, and 66 percent of companies have recorded better-than-expected earnings, leaving profits on track for 8-10 percent year-on-year growth. And central banks are likely to remain highly accommodative, given the extreme deflationary pressures coming from commodity markets, and the reactive nature of modern monetary policy.

Indeed, among the notable features of the most recent sell-off has been the violent positive reaction in core government bond markets. This has helped cushion diversified portfolios somewhat against equity market declines. The U.S. 10-year government yield briefly fell through 2 percent, indicating market expectations that the likes of the Federal Reserve could shift to a more dovish stance in the coming months. Meanwhile, eurozone five-year inflation swaps have fallen below 1.7 percent, which could also encourage the European Central Bank to consider further action.

We have made two investment changes amid the selloff. First, we have removed our overweight position in Canadian stocks. After a strong start to the year, Canadian equities have been adversely affected by the sharp decline in global energy prices: Western Canada Select crude oil prices have dropped from $80 a barrel to $68 over the past month. While we think that the decline in oil prices is likely overdone at these levels and expect a production cut from the Organization of Petroleum Exporting Countries (OPEC) in the coming weeks to stabilize global prices, Canadian equities are likely to remain volatile while oil prices trade close to marginal production costs.

Simultaneously, we have increased our overweight position in U.S. high-yield credit. Following the recent sell off, U.S. high yield bonds yield roughly five percentage points more than U.S. Treasurys. We remain confident that the decline in energy prices will not have a material impact on high yield issuers in the energy sector, given that break-even prices are below $50 a barrel on average and the sector is not highly leveraged. With the fundamental economic situation in the U.S. still positive, we expect default rates to remain below 2 percent, allowing for a total expected return of 5-6 percent over the coming six months, based on our forecasts.

Our overweight positioning is now concentrated in U.S. – the region of the world with the most positive economic growth impulse – and we are overweight both U.S. equities and U.S. high yield credit. We also remain overweight the U.S. dollarrelative to the euro: even if the Fed adopts a more dovish stance it is still likely to increase rates significantly earlier than the ECB.

From here we expect some stabilizing factors to help further boost U.S. growth. First, the decline in long-dated mortgage rates will likely support housing activity – 30-year US swap rates have declined from 3.35 percent to 2.85 percent in just the past month. Second, the decline in energy prices has fed through into gasoline prices which are now at the lowest level since early 2011. This should support consumption. Finally, should inflation or growth surprise to the downside we expect the Fed to remain reactive. In this respect Wednesday's negative U.S. producer price inflation print should be observed with interest.

We will continue to monitor market and economic developments. Signs of continued strength in U.S. macroeconomic and corporate data would likely lead us to increase our cyclical bias. Narrowing differences between yields on U.S. Treasuries and high yield credit would also likely be supportive for future positive returns in equities. Equally, a deterioration of some or all of the above could lead markets to question the sustainability of global growth, in which case we would likely look to reduce positions in risky assets. But as things stand, we believe investors should still regard positive returns from diversified risky assets as a base case scenario over the next six months.